Who Buys and Sells Options: The Role and Pricing of Options in an Economy with Background Risk

38 Pages Posted: 11 Nov 2008

See all articles by Gunter Franke

Gunter Franke

affiliation not provided to SSRN

Richard C. Stapleton

University of Strathclyde - Department of Accounting and Finance

Marti G. Subrahmanyam

New York University (NYU) - Department of Finance

Date Written: December 1995

Abstract

In this paper, we derive an equilibrium in which some investors buy call/put options on the market portfolio while others sell them. Also, some investors supply and others demand forward contracts. Since investors are assumed to have similar risk-averse preferences, demand for these contracts is not explained by differences in the shape of utility functions. Rather, it is the degree to which agents face other, non-hedgeable, background risks that determines their risk-taking behavior in the model. We show that investors with low or no background risk have a concave sharing rule, i.e., they sell options on the market portfolio, whereas investors with high background risk have a convex sharing rule and buy these options. A general increase in background risk in the economy reduces the forward price of the market portfolio. Furthermore, the prices of put options rise and the prices of call options fall. Investors without background risk then react by choosing a sharing rule with higher slope and concavity.

Suggested Citation

Franke, Gunter and Stapleton, Richard C. and Subrahmanyam, Marti G., Who Buys and Sells Options: The Role and Pricing of Options in an Economy with Background Risk (December 1995). NYU Working Paper No. FIN-95-021. Available at SSRN: https://ssrn.com/abstract=1298334

Gunter Franke (Contact Author)

affiliation not provided to SSRN

No Address Available

Richard C. Stapleton

University of Strathclyde - Department of Accounting and Finance ( email )

Curran Building
100 Cathedral Street
Glasgow G4 0LN
United Kingdom
+44 1524 381 172 (Phone)
+44 1524 846874 (Fax)

Marti G. Subrahmanyam

New York University (NYU) - Department of Finance ( email )

Stern School of Business,
44 West 4th Street, Suite 9-68
New York, NY 10012-1126
United States
212-998-0348 (Phone)
212-995-4233 (Fax)

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